Yuan: The hero turns villain

Given the large trade imbalance between the US and China, a recent US Government report argues that the yuan should be revalued upward. The crux of the issue is that by pegging its currency firmly to the dollar at artificially lower levels, China is virtually subsidising its exports through an exchange rate protectionist policy. If China were to give in to the pressure and revalue its currency by 25-30 per cent, India could well emerge as an exciting destination for FDI flows. Business and government need to be proactive on this issue.

PRESSURE is mounting steadily on China to revalue the yuan or even let the currency float. The US Government's 2004 Report to Congress of the US-China Economic and Security Review Commission indicates that pressure is mounting even within the US to ensure such a revaluation is carried out by China at the earliest. Other countries, including Japan and Europe, have also voiced their support for a stronger yuan.

The dollar has depreciated sharply over the past 18 months against most major currencies. Since January 2002, the dollar it devalued 33 per cent against the euro, 16 per cent against the yen, and 14 per cent against the Canadian dollar. In addition, it has also fallen significantly against other currencies such as the pound sterling and the Australian dollar.

However, there has been no adjustment of the dollar against the Chinese yuan, which is fixed through official intervention. Since the yuan is pegged to the dollar, it too has in effect suffered depreciation against major currencies of the World.

In effect, one of the world's most competitive countries has seen its currency weaken significantly albeit in an indirect manner, making an already formidable export machine much more so.

US-China trade Trade between the US and China has burgeoned in recent decades. The value of the bilateral trade between the two countries exceeds $180 billions per year (see Graph). It also shows that the US trade deficit with China, which was $103 billion in 2002, reached $124 billion in 2003.

Over the past 10 years, the US' deficit with China has grown at an average rate of 18.5 per cent, and if it continues growing at this rate, it is expected to double in approximately four years.

Moreover, US goods trade with China is by far the US' most lopsided trade relationship as measured by the ratio of imports to exports for the US.

Axiomatically, China depends heavily on the US market, with exports to the latter constituting 56 per cent of total Chinese exports in 2003, while only four per cent of US exports go to China.

According to the 2004 Report to the Congress by the Security Review Commission, the trade deficit with China is of major concern because of the following reasons:

It has contributed to the erosion of manufacturing jobs in the US;

Manufacturing is critical for the nation's economic and national security; and

The deficit has adversely impacted other sectors of the US economy as well.

Then hero, now villain Economic fundamentals suggest that the Chinese yuan is undervalued as a result of such repeated one-way interventions, with a growing consensus of economists estimating the level of under-valuation to be anywhere from 15 per cent to 40 per cent.

However, China persistently intervenes in the foreign exchange market to peg its exchange rate at 8.28 yuan per dollar. This value of the yuan was pegged to the dollar in 1997.

Given the large trade imbalance between the US and China, the Report to Congress argues that the yuan should be revalued upward.

The crux of the issue is that by pegging its currency firmly to the dollar at artificially lower levels, China is engaging in what amounts to subsidising its exports through an exchange rate protectionist policy.

It is alleged that this artificially low exchange rate inhibits the growth of imports into China and encourages exports from the country. The Chinese, for their part, argue that a stable yuan is essential to maintaining Asian economic stability.

In fact, during the Asian financial crisis of the late 1990s, China steadfastly defended the yuan at this rate.

China was widely applauded world over for doing so because this action was believed to have prevented a round of competitive currency devaluations in Asia and containing the Asian contagion from spreading any further.

But times have changed and the world now perceives the then hero to be a villain!

It is alleged that this manipulation of the exchange rate of the yuan is not in line with the spirit of the WTO's principle of free and fair trade, especially under Article XV of the GATT, which stipulates that members should not take exchange rate actions that "frustrate the intent of the provisions of this agreement".

The intent of the agreement is stated in the preamble, which declares the objective as "entering into reciprocal and mutually advantageous arrangements directed to the substantial reduction of tariffs and other barriers to trade."

Similarly, under Article IV, Section 1, of the IMF's Articles of Agreement requires members to "avoid manipulating exchange rates or the international monetary system to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members."

While the IMF does not prohibit a fixed exchange rate mechanism as that of the Chinese, it surely prevents the exchange rate being set too low, which would, therefore, necessitate the need for protracted, large-scale, one-way market intervention to prevent appreciation.

This is the IMF's definition of currency manipulation. Experience has shown us that this is how a country maintains an undervalued currency to gain competitive advantage in the world trade. The report states that there can be little doubt that China has been engaged in extensive "protracted large-scale intervention in one direction". Such intervention has China's central bank buying dollars in exchange for yuan deposits in the Chinese banking system.

Between December 2000 and December 2003, foreign exchange holdings of China's central bank more than doubled from $166 billion to $403 billion.

What the US seeks to do now

Consequently, the report pleads with the US Government for an immediate and significant upward revaluation of the Chinese yuan vis-à-vis the dollar, which it expects would reduce the US trade deficit with China.

It also suggests that other East Asian countries — Japan, Taiwan, South Korea — would, as a direct consequence of the yuan revaluation, "cease improperly intervening in currency markets to gain competitive advantage".

It must be noted that these countries run large trade surpluses with the US and keep their exchange rates low, in part, to stay competitive with China.

Pushed to the wall, it seems that the US is forced to act now. With increased job loss and flight of manufacturing sector from the US, these interventionist mercantile policies of China are having a debilitating effect on the US.

Further, the trade deficit of the US for the current year is expected to be in the region of $800 billion , which is far above what even the US can sustain. More important, the report predicts that the currency of many South-East Asian countries are competitively devalued in harmony with the Chinese yuan.

To bridge the trade deficit gap, the US has to ensure that the yuan is first revalued and, in tandem, certain other currencies of its major trading partners (such as Japan, Korea and Taiwan, for instance) too are revalued.

As a very serious recommendation, this report urges that the US Government to use the provisions of The 1988 Omnibus Trade and Competitiveness Act, which require the Treasury Department to examine whether countries are manipulating their exchange rates for purposes of gaining international competitive advantage. The Treasury is to arrive at its finding in consultation with the IMF.

All this has tremendous implications for the Indian economy. If China were to revalue its currency by 25-30 per cent, then India could well emerge as an exciting destination for FDI flows.

Further, the revaluation of the yuan could make Indian exports that much more competitive, especially in areas such as auto parts, textiles, leather and certain agriculture products, where India is in direct competition with China. With India clocking an impressive 25 per cent increase in exports for the first four months of this financial year, exporters could be in for exciting times, should the yuan be revalued.

In the modern integrated world, what matters is not only one's own competitiveness but also that of our competitors.

The concept of absolute competitiveness has given way to the theory of relative competitiveness. However, one should not be naïve enough to believe that the revaluation of the yuan would automatically translate into some sort of competitive advantage for business India.

As a nation, India cannot be supinely indifferent to such a major economic development. It needs to be proactive on this matter and one is indeed surprised at the complete lack of any initiative from the business or the government on this vital issue.

Strategically, it would suit India to align with the US on this matter and try to pressure China to accept the revaluation. Since the dynamics involved in international trade and currency valuation is complex, it is felt that the trade, business and the government must come together at the earliest and aggressively take up this issue and come out with a comprehensive strategy.